Conflicts of interest back on ASIC radar

Page Tools

The Australian Securities and Investments Commission's decision
to bring broking firm BBY to heel over its failure to maintain a
"Chinese Wall" between its corporate advice department and its
research department is a sign that the regulator is coming to grips
with real world problems raised by a single, new paragraph in the
Corporations Law.

Last year's Clerp 9 corporate law reform package was the Howard
Government's main response to the corporate governance shambles
exposed by the collapse of the dotcom boom.

Among many other things, it amended the Corporations Act to
require financial service licence holders to "have in place
adequate arrangements for the management of conflicts of interest
that may arise " The amendment wanders on for a couple more
lines but that is its essence. The law makers left it up to ASIC to
define conflicts, and whether they should be managed or avoided
entirely.

That is not an easy task, in the capital markets particularly.
The uncomfortable fact is that modern investment banks are designed
to harness services that produce conflicts.

The standard industry defence is that such conflicts can be
avoided, or managed away by structures such as Chinese Walls -
invisible "don't ask, don't tell" barriers that are meant to
quarantine key departments from each other. But on Wall Street
after the dotcom crash in 2000, we saw how Chinese Walls could
break down. The crash exposed a host of seedy examples of
investment banks placing their own interests ahead of those of
their clients: by tailoring research on companies to suit the
marketing needs of the corporate advisory arm of the investment
bank, for example, and by giving key clients inside running on hot
share offers, for another.

ASIC investigated the investment banks here in 2003 but by that
time the industry was cleaning up its act and the regulator's
conclusion that the local industry had no serious questions to
answer surprised nobody.

Last week's action against BBY shows however that the regulator
is taking a more active approach and a much more sceptical one.

ASIC built on the bare bones provided by Clerp 9 at the end of
August last year with a policy statement that set out ways for
financial services firms to manage conflicts.

It said conflicts needed to be handled in one of three ways when
they arose, depending on the nature of the conflict. Most conflicts
could be managed by disclosure and "internal controls", ASIC said.
But some conflicts were so serious that "the licensee must avoid
the conflict or refrain from providing the affected service".

The policy statement gave a few examples of conflicts that
should be avoided, rather than managed. They included the provision
of positive advice about an investment solely on the basis of
commissions or other benefits, after-hours trading for favoured
clients, and "front-running", in which firms or associated trade
profitably in shares ahead of trades in the shares that clients
have already placed.

A few months later, ASIC issued a supplementary guide for
research analysts that stressed that the research department needed
to be separate from the parts of the investment bank that advise
companies on strategy and capital raisings, and from the investment
bank's trading rooms.

It was all worthy stuff. But it was also wordy stuff, as the BBY
action shows. You can have lots of guides and theories but they
don't mean much if they aren't actually put to work. In the BBY
case, ASIC found that the broking firm did have procedures in place
for handling conflicts. It just didn't apply them when it published
bullish research about a company that it was also advising.

More actions, involving larger firms, are expected. BBY was the
regulator's first conflict of interest action since the Clerp 9
amendment but would not be its last, compliance director Jennifer
O'Donnell said.

The regulator intends to produce a portfolio of real-life
"tabloid scenarios" portraying conflict situations, including
remuneration packages for broker client advisers that are based
overwhelmingly on how much turnover they generate; share allocation
policies, which appear to often direct celebrity shareholders into
celebrity floats; and declarations of interest and potential
conflicts of interest, which were beefed up after the dotcom crash
but have degenerated into "catch-all" boiler-plate statements that
are as meaningless as they are lengthy.

One of the unanswered questions is whether ASIC will point to
more areas it thinks should be totally avoided. It is certainly
considering doing so. Another interesting question is whether the
regulator will take on "Conflict Central" in the investment banking
business - the Equity Capital Markets (ECM) desk.

Equity Capital Markets is what used to be called the
underwriting department. Its main job is to sell shares or other
paper on behalf of corporate clients, and that role puts it at the
centre of the big corporate deals that investment banks do.

The firm's corporate advisory department might, for example,
advise a company on an aquisition, or, as quite often occurs, bring
the deal to the company. ECM can help fund the purchase by placing
new shares in the acquiring company with investors. And if it does,
it will often be armed with research by the firm's specialist
analyst, assessing the deal that the share sale is funding.

Chinese Wall theory says this is possible without creating
conflicts. Analysts are, for example, "taken over the wall" ahead
of the deal, to enable them to assess it, but do not publish
anything until the deal is announced.

As ASIC steps up its scrutiny of conflicts of interest, it is
surely going to have to ask whether this system is as clean as it
purports to be. Even if the analyst is quarantined behind the wall,
can the document he or she produces be untainted by the need of the
firm more generally to get the issue away, in order to complete the
takeover, and win big advice fees on the entire deal?

It will be interesting to see if an enlivened ASIC grasps the
nettle, and declares that in broking and investment banking there
are conflicts that are unmanageable, and must therefore be
avoided.

Interesting too to see if it thinks ECM desks should be taken
on. ECM is the profit powerhouse in the securities industry. The
firms that don't have it want it, and the firms that do have it are
top of the league tables. They will respond to any suggestion that
ECM is not on the up and up, with vigour, and, quite possibly,
venom.